Do individual investors drive post-earnings announcement drift? Direct evidence from personal trades David Hirshleifer* James N. Myers** Linda A. Myers** Siew Hong Teoh* *Fisher College of Business, Ohio State University **College of Commerce and Business Administration, University of Illinois at Urbana-Champaign August 2002 JEL Codes: G14, M41 We thank Allen Poteshman, Terry Shevlin, Avanidhar Subrahmanyam, Sheridan Titman, and seminar participants at Ohio State University, University of Illinois at Urbana- Champaign, University of Michigan, University of Maryland, Pennsylvania State University, and Washington University for helpful comments.
Do individual investors drive post-earnings announcement drift? Direct evidence from personal trades This study examines whether individual investors are the source of post-earnings announcement drift (PEAD). We provide evidence on how individual investors trade in response to extreme quarterly earnings surprises and on the relation between individual investors trades and subsequent abnormal returns. We find no evidence that either individuals or any sub-category of individuals in our sample cause PEAD. Individuals are significant net buyers after both negative and positive earnings surprises. While postannouncement individual net buying is a significant negative predictor of stock returns over the next three quarters, individual investor trading fails to subsume any of the power of extreme earnings surprises to predict future abnormal returns. Keywords: post earnings-announcement drift; trading activity; individual investors
I. INTRODUCTION This paper examines whether post-earnings announcement drift, or PEAD (Foster, et al. 1984; Bernard and Thomas 1989, 1990), results from trades made by individual investors. PEAD is the tendency for stocks to earn high positive average abnormal returns in the three quarters subsequent to extreme positive earnings surprises, and, more strongly, to earn negative average abnormal returns in the three quarters subsequent to extreme negative earnings surprises, where an earnings surprise is calculated as the difference between the current quarter s earningsper-share and split-adjusted earnings-per-share four quarters prior. Bernard and Thomas (1990) suggest that PEAD is due to investors naively forecasting earnings. 1 Furthermore, recent studies suggest that PEAD may result from the trading activity of individual investors. These studies are motivated by a literature that argues that individual investors are less sophisticated than institutional investors, and that the trading of individual investors is the sources of market inefficiencies (e.g., Hand 1990; Lee et al. 1991; Grinblatt and Keloharju 2000). 2 One such study, Bartov et al. (2000), finds that PEAD is strongest in firms with low institutional shareholdings. 3 Furthermore, Bhattacharya (2001) provides evidence that the volume of small trades but not large trades is associated with the magnitude of random walk 1 Papers that examine the serial correlation of earnings and returns in greater detail have concluded that this evidence is consistent with less naiveté than is suggested by Bernard and Thomas (1990) (Ball and Bartov 1996) or with no naiveté (Soffer and Lys 1999; Jacob et al. 2000) about the time series of earnings. Our purpose here is not to estimate investor perceptions about the time-series process for earnings. Rather, we examine whether the trading pattern of individual investors is consistent with predicted behavior under the hypothesis that trading by individual investors drives PEAD 2 Although evidence suggests that individual investors make poor investment decisions on average (Barber and Odean 2000), other evidence indicates that some individuals possess superior investment skills (Coval et al. 2001). 3 However, results from tests of whether the level of institutional shareholdings is a good proxy for investor sophistication are mixed. Because of this, the authors indicate that their results do not provide strong evidence about whether individual investors cause PEAD. 1
earnings surprises, suggesting that investors who make small trades may underlie the PEAD phenomenon. In this paper, we offer more direct tests of the hypothesis that individual investors cause PEAD by examining individual investor trading following earnings announcements. Using a database that includes all trades made by a sample of individual investors through a major discount brokerage firm from 1991 through 1996 inclusive, we examine whether individuals tend to make contrarian trades in opposition to the direction of the market price response to earnings surprises. To the extent that individual trades can impede a full price response, their trading would intensify PEAD. In addition, we examine the relation between individual trading and subsequent abnormal returns. Past empirical work on trading in response to earnings announcements shows that earnings announcements stimulate trading volume. 4 In general, public news announcements can generate trading volume both by resolving uncertainty, thereby creating consensus and triggering unwinding trades, and by providing information which generates disagreement and results in the taking of speculative positions. Investors who have differing information prior to a news announcement or who have different information-processing abilities may interpret earnings news differently, and may therefore trade differently in response (Karpoff 1986; Demski and Feltham 1994; Kim and Verrecchia 1994, 1997). Most past empirical studies have focused on unsigned volume, and any identification of traders is inferred from the size of the trade. However, in order to examine whether trading by individual investors causes PEAD, it is useful to determine whether they are trading in the same 4 Several studies show that the effect of accounting disclosure on volume is related to the size of the earnings surprise (e.g., Bamber 1986, 1987; Ziebart 1990; Kross et al. 1994), to firm size (e.g., Bamber 1986; Ziebart 1990; Atiase and Bamber 1994; Bhattacharya 2001), and to the degree of information asymmetry prior to the information release (e.g., Ziebart 1990; Ajinkya et al. 1991; Atiase and Bamber 1994; Utama and Cready 1997). 2
direction as the earnings surprise (net buying after good news and net selling after bad news) or in opposition to it. Our database allows us to make this determination. In a related paper, Lee (1992) examines the inferred-signed trades of investors in relation to earnings news. Measuring the sign of the earnings surprise relative to the most recent Value Line earnings forecast, he finds that small trades tend to be inferred-buys for more than two days after both favorable and unfavorable earnings surprises. Lee assumes that it is individual investors who are making these small trades and he suggests that his findings are consistent with earnings announcements drawing the attention of individual investors to the stock. Our study differs from Lee s in that we examine only extreme earnings surprises (which are the source of the drift), directly identify individual traders rather than use the size of the trade as a proxy for whether the trader is an individual or an institution, and directly identify the direction of the trade (i.e., whether the trade is a buy or sell) rather than use the price relative to the bid-ask spread as a proxy for whether the trade was initiated by a buyer or seller. We build on previous literature by making a more detailed examination of the buying and selling behavior of individual investors around extreme earnings surprises. In this way, we provide a focused examination of whether the trades made by individual investors explain PEAD. Furthermore, we apply two proxies for individual investor sophistication (capital invested and trading experience) to determine whether the least sophisticated investors (those with relatively little capital invested with the discount broker and/or those with relatively little trading experience) drive PEAD. Our results indicate that individual investors do not cause post earnings announcement drift. We bring two kinds of evidence to bear on this issue. First, we test whether individuals trade in a contrarian fashion in response to extreme earnings surprises. As discussed in section 3
II, if individual trading caused PEAD, investors would be net purchasers after good news and net sellers after bad news. This would reduce the amount by which prices react to earnings news, resulting in underreaction. However, individuals are significant net purchasers after both good and bad news, and this result is unaffected by investor sophistication. Second, we test whether net purchases made by individual investors can subsume the ability of the extreme earnings surprise to predict subsequent abnormal stock returns. We examine the relation between ranked net purchases (RANK NET PURCHASES) immediately following extreme earnings surprises and subsequent abnormal stock market returns and find that, on average, the stocks that individuals net sell following extreme earnings announcements outperform the stock that individuals net purchase following extreme earnings announcements. Although this effect is potentially consistent with individual trades pushing share prices away from fundamental values, it is statistically unrelated to PEAD. In fact, we find that controlling for RANK NET PURCHASES does not diminish at all the ability of extreme earnings surprise to predict subsequent returns. Thus, the evidence in our dataset opposes the proposition that individual investors cause PEAD. However, it is consistent with trading by individuals being influenced by an earnings attention effect. 5 That is, the greater the absolute value of the earnings surprise, the greater the volume bought and sold, but the direction of the news is unrelated to the direction of the trading. The remainder of this paper is structured as follows. Section II explains how trading by individual investors could induce PEAD. Section III contains a description of the data and sample selection criteria, variable definitions, and descriptive statistics. Section IV provides evidence on individual investor trading in relation to earnings surprises. In Section V we 5 For an analysis of the effects of media-reported general news announcements on investor trading, see Barber and Odean (2001). 4
examine the relation between individual trading, earnings surprises, and subsequent stock returns, and Section VI concludes. II. NAÏVE TRADING AND POST-EARNINGS ANNOUNCEMENT DRIFT Several papers suggest that the trading behavior of individual investors may be the source of PEAD. Prior research consistently suggests that drift is associated with high individual shareholding and trading (e.g., Bartov et al. 2000, Bhattacharya 2001). However, if trading by individuals causes PEAD, then their trading must be naïve in a way that systematically causes prices to underreact to earnings news. Before discussing what trading behavior would cause PEAD, we review the PEAD phenomenon. PEAD is typically characterized as an underreaction to earnings news. Bernard and Thomas (1990) show that seasonal random walk quarterly earnings changes are positively serially correlated. That is, after a positive earnings surprise, subsequent earnings surprises tend to be predictably positive, while after a negative earnings surprise, subsequent earnings surprises tend to be predictably negative. Furthermore, stock returns around subsequent earnings announcements tend to be predictable. Specifically, while stock prices generally increase (decrease) after good (bad) news, they do not seem to increase (decrease) enough. In fact, they continue to rise (fall) following the subsequent three quarterly earnings announcements. Bernard and Thomas (1989) suggest that this happens because investors react naively to earnings announcements by failing to recognize the serial correlation in earnings surprises. A group of investors that drives PEAD would trade in a way that opposes a full and rational stock price adjustment in response to earnings surprises. Thus, after favorable earnings news, when price rises, such individuals would, on average, sell the stock, while after bad news, 5
such individuals would, on average, buy. In other words, such individuals would be contrarian with respect to current earnings news. This suggests a simple set of tests of whether individual investors cause post-earnings announcement drift if individuals cause PEAD then they will tend to net buy after negative earnings surprises and net sell after positive earnings surprises. Furthermore, if trading by individuals causes share prices to underreact to earnings news (which manifests as PEAD), then their net purchases must be related to subsequent abnormal stock returns. Therefore, the hypothesis that individuals drive PEAD predicts that individual net selling, which generates underpricing, should predict high subsequent stock returns, and individual net buying, which generates overpricing, should predict low subsequent stock returns. Moreover, if trading by individual investors is a source of the relation between extreme earnings surprises and subsequent returns, then the predictive power of individual trades should remain even after controlling for the magnitude of the earnings surprise. Finally, individual trading after earnings surprises should subsume part or all of the ability of the earnings surprise to predict subsequent returns. It could be argued on prior conceptual grounds that drift could not represent a market inefficiency because if naïve trading were to induce such a pattern of mispricing, smart arbitrageurs would find it profitable to trade to exploit it. Such exploitation would tend to attenuate the pattern. However, a literature in behavioral finance and accounting has argued that despite arbitrage by sophisticated investors, the behavior of imperfectly rational investors can induce mispricing (including PEAD), and under some circumstances, mispricing can persist. 6 If naive investors are subject to common misperceptions, then in the aggregate, these misperceptions may be substantial enough to influence price. (Given such commonality, we 6 See, for example, the models and surveys of DeLong et al. (1991), Shleifer and Vishny (1997), Daniel et al. (1998), Fischer and Verrecchia (1999), Hirshleifer (2001), and Lee (2001). 6
would also expect to see evidence of such misperceptions within our sample of individual investors if individual investors are driving PEAD.) Furthermore, if sophisticated investors are risk averse, the degree to which they arbitrage mispricing may be limited. As discussed earlier, there is also empirical evidence suggesting that the trading of unsophisticated individual investors influences prices. Empirically, several authors have concluded that PEAD represents a market inefficiency (see, for example, Bernard and Thomas 1989, 1990). We do not take a stand on this issue. We merely argue that, given existing theory and evidence, the hypothesis that PEAD is a market inefficiency resulting from individual investor trading deserves to be tested. III. TRANSACTION DATA, SAMPLE SELECTION, VARIABLE DEFINITIONS, AND DESCRIPTIVE STATISTICS Transaction Data The data used in this study comes from a large discount broker. It includes trades made by 78,000 households, using that broker. The broker made 3,075,797 trades on behalf of these households between January 1991 and December 1996 inclusive. 1,969,747 of these trades involve common stock, while the remainder involves mutual fund shares, bonds, and other securities. We classify the households as actively-trading investors (6,000 households), highcapital investors (12,000 households), and general investors (60,000 households). 7 Any investor that conducts more than 48 trades in a year is classified as actively-trading; investors that are not classified as actively-trading and that have more than $100,000 of invested wealth at any time 7 We follow the broker s classification scheme when grouping investors. However, the broker refers to the highcapital investors as affluent. We change this label so that it more accurately reflects the criterion. 7
are classified as high-capital investors; and all remaining investors are classified as general investors. The high-capital and actively-trading investor classifications measure two aspects of investing experience the amount of wealth invested and the frequency of trades. We use these two aspects of investing experience to proxy for investor sophistication. With respect to the amount of wealth invested, an investor who has a greater amount of wealth invested and who intends to trade frequently in the stock market has a greater incentive to invest resources learning about stock trading. 8 Furthermore, greater invested wealth may be associated with past stock market success. With respect to the frequency of trades, investors may learn through experience about the time series property of earnings and about market price patterns. This suggests that more sophisticated individual investors may be better at avoiding errors in trading in response to earnings announcements, or may even be good at exploiting PEAD. Sample Selection And Variable Definitions Our sample consists of all firm-quarters with sufficient Compustat data with at least one trade made during the following 13 months by our sample of investors. 9 From Compustat, we require primary earnings per share before extraordinary items (quarterly data item 19) at both quarter t and quarter t-4, price per share at the end of quarter t (quarterly data item 14), and the corresponding split adjustment factors (quarterly data item 17). Additionally, we require an earnings announcement date and the number of shares outstanding at the end of the quarter 8 Consistent with this, Cready (1988) finds evidence consistent with wealthy institutional investors trade more quickly in response to earnings announcements, suggesting that the value of information increases with wealth. 9 This sample selection criteria is much less strict than that used by Lee (1992) or Bhattacharya (2001). In these studies, firms must have an average of at least 10 trades per day over the prior year to be included in the sample. Because our data represents only a small subset of the total number of trades, imposing this criterion would reduce the sample size by more than 95 percent. However, imposing this criterion (an average of at least 10 shares traded per day) does not materially affect the main results of our study. 8
(quarterly data item 61). Using the Compustat data, we construct the standardized unexpected earnings (SUE) as the seasonal difference in split-adjusted earnings per share scaled by the splitadjusted end of quarter price (i.e., the price at the end of the quarter prior to the earnings announcement). We define SUE 1 firms as the 10 percent of firms with the most negative random walk earnings surprise, SUE 10 firms as the 10 percent of firms with the most positive random walk earnings surprise, and SUE 5 and 6 firms as the 20 percent of firms with the smallest (in absolute value) random walk earnings surprise. For each firm-quarter, we identify all trades of the firm s common stock made by our sample of investors during the following quarter. We measure the trading activity over various event windows, ranging in length from one day to a whole quarter. For example, we measure the trading activity on the earnings announcement day for quarter q, for firm j, by summing the number of common shares of firm j traded by any investor in the dataset on the earnings announcement day. We scale this sum by the number of common shares outstanding for firm j at the end of quarter q. We repeat this procedure for subsamples of trades (i.e., for buys and sells) and for subsamples of investors (i.e., for high-capital investors, actively-trading investors, and general investors). We measure net purchases as the difference between the number of shares purchased and the number of shares sold in the event window, scaled by millions of shares outstanding at quarter-end. 10 A challenge for calculating abnormal trading activity is that the normal trading benchmark for individual firms is difficult to identify because, as we discuss later, earnings surprises seem to affect the frequency of trading over long periods. Therefore, we compare how 10 When the number of shares purchased exceeds the number of shares sold in the event window, net purchases is positive. When the number of shares sold exceeds the number of shares purchased in the event window, net purchases is negative. 9
individual investors trade the shares of firms with extreme earnings surprises with how they trade the shares of firms with little or no earnings surprise. That is, we consider individual trades in the shares of firms in SUE 5 and 6 as the benchmark, and test how the trades of shares of firms in SUE 1 and of firms in SUE 10 differ from this benchmark. Since prior literature has found PEAD to be stronger in small firms (Foster et al. 1984; Bernard and Thomas 1989, 1990), we also partition the firms based on their market value of equity at quarter end. Using alternative size measures, we verify that these findings hold when only small firms are considered. Descriptive Statistics Our final sample consists of 941,210 trades made in the 13 months following 65,703 earnings announcements. 54 percent of these trades are buys, with a mean number of shares purchased of 512, and 46 percent of these trades are sells, with a mean number of shares sold of 594. 11 Although 76.9 percent of the investors are classified as general investors, these investors make only 40 percent of the trades, and the 15.4 percent of the sample that is classified as highcapital investors make only 11.4 percent of the trades. The remaining 48.6 percent of the trades are made by the 7.7 percent of the sample that is classified as actively-trading investors. Further descriptive statistics are provided in Table 1. Panel A of Table 1 describes the distribution of trade size of both buys and sells by year. It is interesting to note the large number of large trades in the database. For example, the trade size is greater than $5,000 for approximately half of the trades and at least 500 shares are traded in more than 25 percent of the trades. Since prior studies use either the number of shares traded or the dollar value of the transaction to classify trades as being initiated by individuals or institutions, prior studies would 11 Table 1 descriptive statistics differ slightly from these because the Table 1 sample includes all trades of common stock and the Table 1 sample is not restricted to trades of firms with available Compustat data. 10
classify these large trades as either institutional trades or as indeterminate. The wide variation in the frequency of trading among individuals is also of interest. Panel B shows that while the median individual trades 4 times per year for a total of approximately $21,000, the median actively-trading investor trades 22 times a year for approximately $158,000. It is also interesting to note how highly skewed the trading volume (measured in dollar value and number of trades) is. For example, the mean trading volume, measured in dollars per year, is greater than the third quintile indicating that there are a few very large trades. Finally, actively-trading investors trade, on average, 6 times as often and 10 times as much (in dollar value) as general investors, and more than 4 times as often and more than 5 times as much (in dollar value) as high-capital investors. Because the actively-trading investors are indeed highly active, it is plausible that these investors may be disproportionately important in generating the empirically observed price patterns. On the other hand, these traders may be more sophisticated than other individual investors, suggesting that they are not the source of PEAD. Put Table 1 about here. IV. INDIVIDUAL INVESTOR TRADING FOLLOWING EXTREME EARNINGS SURPRISES In this section, we discuss the trades made by individual investors following extreme earnings surprises. Furthermore, we describe the trading behavior of the three investor groups: General Investors, High-Capital Investors, and Actively-Trading Investors. Trading by Individual Investors Following Extreme Earnings Surprises The hypothesis that individuals cause post-earnings announcement drift suggests that individuals will buy after extremely bad earnings news (pushing the stock price up) and sell after extremely good earnings news (pushing the stock price down). As described previously, in the 11
first set of tests, we examine the trades made by individual investors following extreme earnings surprises (SUE 1 firms and SUE 10 firms) and compare these to the trades made by individual investors following earnings announcements with little or no surprise (SUE 5 and 6). Figure 1 reveals that in the 25 trading days following an extreme earnings announcement, cumulative abnormal net purchases made by individual investors are greater on average for SUE 1 (bad news) firms than for SUE 10 (good news) firms. 12 However, two aspects of this evidence sharply contradict the proposition that individual investors cause PEAD. First, individuals are net purchasers after both good news and bad news. This confirms the finding in Lee (1992) for extreme earnings news, and confirms directly that this effect is due to individual investors. This net buying by individuals in SUE 10 firms during the 16 days following an extreme earnings surprise is inconsistent with the hypothesis that individual investor trade against favorable earnings news, causing underreaction and subsequent drift. Second, the difference in cumulative net purchases between good news and bad news firms does not develop until 17 days (i.e., more than three weeks) after the earnings announcement so differences in individual trading cannot explain any under- or overreaction in the days following the earnings announcement. Put Figure 1 about here. Table 2 provides numerical statistics that confirm the pattern in Figure 1. Panel A (B), reports differences in mean number of shares traded (buys, sells, and net purchases) per million shares outstanding between extreme good news (bad news) firms and no news firms. In the first 15 days following an extreme earnings surprise, there is statistically significant buying and 12 Cumulative net purchases is the sum of shares purchased minus the sum of shares sold beginning on the day following the earnings announcement and ending on day t, scaled by the number of shares outstanding at the end of the quarter for which earnings is announced. Cumulative abnormal net purchases is the difference between cumulative net purchases for SUE 1 (SUE 10) firms and cumulative net purchases for SUE 5 and SUE 6 firms. 12
selling for both good and bad news firms (relative to no news firms). Note that the significant net purchases following good news contradict the hypothesis that individuals are causing PEAD. In fact, the only aspect of the evidence suggesting that individuals may contribute to drift is that net purchases are larger, more significant, and more persistent following bad news. Indeed, following good news, there is insignificant net selling beginning 16 trading days (i.e., more than three weeks) after the earnings announcement. However, the difference between the net purchases following good vs. bad news is not significant in the first three weeks of trading following an earnings announcement. 13 Overall, this evidence suggests that individuals are influenced by an earnings attention effect, but there is no indication that individuals systematically engage in the earnings-contrarian form of trading that would induce underreaction and so cause PEAD. Trading by Individual Investors Following Extreme Earnings Surprises in Small Firms Prior literature finds that PEAD is more prevalent in small firms (Foster et al. 1984; Bernard and Thomas 1989, 1990). Since individual investors tend to be disproportionate holders of the shares of small firms, several authors have suggested that smaller firms are more likely to have a less sophisticated shareholder base (Lee et al. 1991; Potter 1992; Walther 1997). To test whether individuals investing in small firms are causing PEAD, we examine how investors trade following extreme earnings surprises at small firms. Table 3 replicates the analysis from table 2 for firms with market value of equity less than the median in the sample. That is, we classify 13 In an efficient market, prices react immediately so if individual investors were driving underreaction, they would need to trade in opposition to the earnings surprise from the first days after the announcement. 13
firms as small or large based on their market value of equity (MVE) at the end of the fiscal quarter and define firms with MVE less than the median as small firms. 14 Put Table 3 about here. Since investors in the dataset tend to invest in large firms, the sample size is reduced by approximately two-thirds. The statistical power is therefore reduced but the results of this analysis are largely consistent with those using the entire sample. Although individuals sell more shares following good news than in the benchmark case of no-news, they also sell more shares following good news. Resulting net purchases (buys sells) is not significantly different for good news vs. no news firms. Furthermore, the signs on net purchases are consistent that using the full sample (i.e., they support an attention effect) but net purchases is not significantly different from zero in three of four windows. Thus, even in small firms, where PEAD is strongest, there is no evidence that individuals cause PEAD. Trading by Individual Investor Class Even if individual investors as an aggregate do not drive drift, there could be important trading effects concentrated in particular classes of investors. The activities of naïve individual investors could be masked in the aggregate by arbitrage on the part of more sophisticated individual investors trading to profit from PEAD. We therefore examine specifically those investor classes that are most likely to be either less or more sophisticated. As discussed previously, there is reason to believe that investors with more capital invested and more experienced traders may be more sophisticated in their processing of information. Therefore, we expect high-capital investors and actively-trading investors to be more sophisticated, on average, 14 We also replicate this analysis using the bottom decile of MVE as our measure of small firms and find essentially identical results. However, the sample size is reduced to approximately 900 firms and the statistical power is significantly reduced. 14
than general investors. We test whether the least sophisticated individuals general investors drive PEAD and whether high-capital investors and actively-trading investors trade in a way that masks the effect in aggregate. Panel A (Panel B) of table 4 tests whether net purchases are significantly different for extreme good news (bad news) and non-news earnings announcements for the three classes of investors (high-capital investors, actively-trading investors, and general investors). Put Table 4 about here. Contrary to our expectations, we find no evidence that the general investors drive PEAD. Trading by general investors does, however, support the earnings attention effect in that these investors are net purchasers after both good and bad earning news. Furthermore, we find no evidence that more experienced or high capital individual investors exploit PEAD. While highcapital investors are net sellers following good news (an earnings-contrarian behavior), these results are insignificant. Finally, trading by actively-trading investors strongly supports an earning attention effect, but these investors do not appear either to cause or to take advantage of PEAD. In summary, the evidence on individual investor trading does not support the hypothesis that individuals or any class thereof are trading in a manner that would cause PEAD. V. INDIVIDUAL INVESTOR TRADING AS A PREDICTOR OF POST- EARNINGS ANNOUNCEMENT DRIFT As discussed in section II, if trading by individual investors causes PEAD, then their net trading should negatively predict subsequent stock market returns. Furthermore, net trading by individuals should subsume part or all of the explanatory power of the earnings surprise for predicting subsequent abnormal stock returns. In this section, we examine the relation between 15
individual investor trading and subsequent market-adjusted returns for the sample of investors as a whole and for the individual investor classes described previously. Trading by Individual Investors and Subsequent Returns Previous studies (e.g., Bernard and Thomas 1989; 1990) find that PEAD is strongest among firms with relatively extreme earnings surprises. This suggests that we may be able to increase the power of our tests by focusing on firms with relatively extreme earnings surprises. This filters out the noise from firms with modest SUEs and little PEAD. On the other hand, when we restrict the sample to those firms with the most extreme SUEs (e.g., to those firms in deciles 1 and 10), most of the data is excluded. As a compromise, we restrict the sample for the subsequent analyses to those 11,480 firms in SUE deciles 1 to 3 or 8 to 10 15 and to those firms with non-zero net buys in the 5 days following the earnings announcement. 16 Table 5 reports the results of regressions of returns (measured over the 9 and 6 months subsequent to the earnings announcement) on SUE (the decile rank of the earnings surprise) both with and without controlling for past momentum. To control for market-to-book and size, we add the decile rank of the firm s market-to-book ratio (MTB) and the decile rank of the firm s market value of equity (MVE) as regressors. We measure momentum as the market-adjusted buy and hold returns over the 6 months prior to the earnings announcement date. The coefficients on SUE are strongly significant. This confirms that after controlling for size, market-to-book, and past momentum, the PEAD effect was strong during the time period. Thus, this time period is appropriate for testing whether individual investor trading drives PEAD. 15 When we run our analyses on firms in deciles 1 and 10 of SUE, the coefficients have the same sign but are insignificant because the small sample size reduces the power of our tests. Using SUE deciles 1 to 2 and 9 to 10 or including firms in all SUE deciles provides results similar to those reported. 16 Including those firms with zero net-buys provides almost identical results. 16
We next examine the effect of including the decile rank for net buying of the firm (RANK NET PURCHASES) in the regression. Specifically, RANK NET PURCHASES is the decile rank based on the number of shares purchased minus the number of shares sold from day +1 to day +5 relative to the earnings announcement date, scaled by the number of shares outstanding at the end of the fiscal quarter for which earnings is announced. Table 5 reveals that individual investor trading in the five days following extreme earnings announcements (RANK NET PURCHASES) is a significant negative predictor of future 6-month and 9-month stock returns, and that this effect is independent of the size and market-to-book effects. The talent that individual investors show for picking losers in their post-earnings announcement trades certainly raises a suspicion that they may be the source of PEAD. However, Table 5 shows that the PEAD effect is not subsumed by individual investor trading. The coefficient on SUE remains highly significant (p<.0001) after RANK NET PURCHASES is included in the regression. One could argue that only a subset of individual investors drive PEAD; if so, including investors outside of this subset adds noise to our analyses. In this case, we may not expect RANK NET PURCHASES to subsume SUE completely. However, including RANK NET PURCHASES in the regression does not detract at all from the magnitude and significance of the SUE effect. This evidence strongly contradicts the hypothesis that trading by individual investors as a group is a source of the PEAD effect. Even after controlling for SUE, RANK NET PURCHASES remains statistically significant. Indeed, the coefficients on RANK NET PURCHASES from regressions that include SUE are larger and more significant than those from regressions (not reported) that do not 17
include SUE. Thus, individual investors have a special skill at picking losers, conditional on an extreme earnings surprise. 17 In summary, these analyses reveal that individual investors trade foolishly in response to extreme earnings surprises in the sense that their trades in the 5 days following these surprises are negative predictors of returns over the next 6 to 9 months. This anti-arbitrage by individual investors suggests that they may be the driving force behind some kind of market inefficiency, perhaps losing money when the market misvaluation is corrected. However, this individual trading effect appears to be unrelated to PEAD. There is no indication from the returns evidence that individual investors drive PEAD. Nor is there any indication that PEAD underlies this individual investor trading effect. Trading by Classes of Individual Investors and Future Returns The results in the previous section rule out the hypothesis that the trades of the individuals in our sample as a group are the source of drift. However, it remains possible that some unsophisticated class of individual investors drives PEAD, and that this is being masked by sophisticated trades in the opposite direction made by another subset of individual investors. Thus, to explore further whether a class of individuals drives PEAD, we report similar returns regressions for each of the investor classes in table 6. Analyses by class reduces the sample size, so statistical significance is generally lower. However, all regressors other than RANK NET PURCHASES remain significant in the 9-month return window, and while the coefficients on RANK NET PURCHASES are insignificant for the affluent class, they remain negative. The significance and magnitude of the coefficients on RANK NET PURCHASES increase from high-capital investors to general investors to actively-trading investors. This 17 This is consistent with evidence, not conditioned on earnings surprises, that individual investor trades on average underperform (Odean 1999; Barber and Odean 2000). 18
suggests that high-capital investors are less skilled at picking losers following extreme earnings surprises, that ranked net purchases made by general investors following extreme earnings surprises are stronger predictors of negative future returns, and that this effect is strongest for actively-trading investors. The key finding, however, is that for all classes of individual investors, adding RANK NET PURCHASES to the regression has virtually no effect on the coefficient or significance of SUE. That is, SUE remains strongly significantly positive in all specifications, and SUE is not subsumed by the trading of high-capital investors, actively-trading investors, or general investors. This evidence strongly opposes the hypothesis that trading by any of these investor classes drives PEAD. VI. CONCLUSION This paper examines whether trading by individual investors drives post-earnings announcement drift, and describes how individual investors trade conditional on extreme earnings surprises. At a broad level, several regularities are of interest. First, the ability of individual trades to predict future returns (Odean 1999) extends to trades taken in response to extreme earnings surprises, and this effect is not subsumed by PEAD. Second, the evidence is consistent with an earnings attention effect: extreme earnings surprises trigger greater trading and greater net buying. Third, abnormal trading is stronger for negative earnings surprises than for positive earnings surprises. Fourth, in the first 17 trading days after an extreme earnings surprise, net buying is fairly similar regardless of whether the surprise is good news or bad news, but starting on day +18, net buying after bad news significantly exceeds net buying after good news. 19
Turning to the main question of the paper, we find no evidence in our sample that trading by individual investors following extreme earnings surprises causes post-earnings announcement drift. Such trading would need to restrain the efficient adjustment of market prices to earnings surprises. In other words, if individuals were causing PEAD, they would engage in earningscontrarian trading, buying aggressively after adverse earnings news and selling after favorable news. However, individuals are strongly significant net buyers in first three weeks following both favorable and unfavorable earnings surprises. Furthermore, while we find that net buying by individual investors in the five days following an extreme earnings surprise is a significant negative predictor of future abnormal returns, these returns are unrelated to PEAD. Our tests provide clear evidence that in our dataset individual investors are not the source of PEAD. If trading by individuals were the source of PEAD, then net purchases made by individual investors following an initial earnings announcement would be able to subsume part or all of the ability of the earnings surprise to predict subsequent abnormal returns. However, this is not the case. Although individual trades are a significant predictor of future stock returns, including ranked net purchases in a regression of SUE on abnormal returns does not weaken the predictive power of the earnings surprise at all. Nor does including the earnings surprise weaken the predictive power of individual trades. Thus, two distinct market inefficiencies seem to exist. The first is PEAD. The second is that, the ranked net purchases made by individual investors in reaction to extreme earnings surprise are negative predictors of future abnormal returns. Finally, the results of our analyses by investor class suggest that high-capital investors are less skilled at picking losers following unusual extreme earnings surprises, that ranked net purchases made by general investors following unusual extreme earnings surprises are stronger predictors of negative future returns, and that this effect is strongest for actively-trading investors. 20
There are some limitations to the tests we perform. Although the number of data points in the sample is large, it includes only those individuals who use a single major brokerage firm over a six-year period. Other groups of individuals may behave differently, and it is conceivable that the behavior of individuals during this time period was for some reason anomalous. Furthermore, there may be further sub-categories of individuals who cannot be identified using the category information of the dataset, but who may behave differently. In summary, there is a clear answer to the question posed in the title of this paper. In our dataset, there is no indication that trading by the individual investors drives post-earnings announcement drift. What, then, is the source of PEAD? There are several possibilities. One is that the effect is a spurious consequence of some sort of measurement problem, such as the imperfect measurement of risk. A second is that individuals drive PEAD in a way that is not identifiable using our dataset. Finally, it is possible that some subset of institutional investors generates PEAD, either because of agency incentives or cognitive biases. 21
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FIGURE 1 Cumulative Abnormal Net Purchases Relative to the Earnings Announcement Date ABNORMAL NET PURCHASES Abnormal net purchases 25 20 15 10 5 0-5 1 3 5 7 9 11 13 15 17 19 21 23 25 Days After the Earnings Announcement SUE 10 minus SUE 5 & 6 SUE 1 minus SUE 5 & 6 SUE 1 firms are firms with the most negative random walk earnings surprise, SUE 10 firms are firms with the most positive random walk earnings surprise, and SUE 5 & 6 firms are firms with the smallest random walk earnings surprise (in absolute value). Net purchases is measured as the number of shares purchased minus the number of shares sold, scaled by millions of shares outstanding at the end of the fiscal quarter for which earnings is announced. 25